ESTRUCTURA AGRARIA

EQUIVALENT OF R&D 2006 2005 2004 Stryker Corp. $324.6 $284.7 $214.9 Zimmer Holdings, Inc. $188.3 $175.5 $166.7 Biomet, Inc. $85.0 $80.2 $65.0 Smith & Nephew plc NR NR NR NR= not reported *all costs in millions

The Theoretical Asset Value was created by finding the expense actually put towards Research and Development. As you can see, the differences between Stryker, Zimmer Holdings, and Biomet in the amounts they invest in R&D are substantial and should be considered when valuing the Company. Also, the fact that one of the companies chose not to disclose their Research and Development expense shows that distortions in accounting statements create difficulty in valuing a firm. Either way, Research and Development is a driving force for the creation of value in the Medical Technologies Industry and it is a disadvantage to analysts not to see it listed as an asset.

Capital and Operating Leases

Another key distortion in analyzing accounting records is the effect of capital and operating leases on the overall liabilities of the firm. Capital leasing gives ownership a company and can give certain benefits, such as amortizing the asset over its useful life. Conversely, operating expenses are treated as a pure rent expense. Since firms

normally would not want to show leases on the books and like to defer expenses, firms try to report as many operating leases as possible. Unfortunately for these firms, the Financial Accounting Standards Board has ruled that a lease should be treated as a capital lease if it meets any one of the following conditions:

(1) if the lease life exceeds 75% of the life of the asset

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(3) if there is an option to purchase the asset at a "bargain price" at the end of the lease term.

(4) if the present value of the lease payments, discounted at an appropriate discount rate, exceeds 90% of the fair market value of the asset.

The person who rents the asset (the owner or lessor) uses the same criteria for determining whether the lease is a capital or operating lease and accounts for it

accordingly. If the lease is shown to be capital, the owner records the present value of future cash flows as revenue and recognizes expenses. For this reason, and the tax incentive for operating leases, many firms try to show as many operating leases as possible. Discerning their effect is important in gaining an accurate view of the firm.

Not valuing the lease as an asset impacts the balance sheet for the firm. Stryker states that they have $62.1 million in operating leases for 2007, and a current maturity of long-term debt of $14.8 million, with no other long-term debt. This means that

Stryker has paid off almost all of its long-term liabilities. Since it is hard to discern which is true from the amount of information their 10-K gives us, we will assume that they only have operating leases for the time being. With this in mind, that means that

operating leases will account for 3.7% of Stryker’s total liabilities and only 1.1% of total assets. We can make a logical assumption that Stryker is not making a substantial material difference in the value of the firm by using operating leases. With this being said, we can also conclude that Stryker is not intentionally trying to distort anyone’s view of the firm’s value.

Defined Benefit Plans and Pension Plans

Defined benefit and pension plans are liabilities to the firm as they represent a debt to be paid to an individual in the future. The amount of debt recorded is the

present value of future expenditures, which makes it subject to a discount rate. Stryker, for the years of 2006 and 2007, has the discount rates of 4.1% and 4.4%, respectively. With current inflation sitting at 4.28% (inflationdata.com), it is good that Stryker is keeping up with current inflation.

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An understatement of their discount rate will result in an overstatement of liabilities; in the inverse situation, overstating the rate would mean an understatement of liabilities. With the current T-bill rate sitting at 4.37% (www.treas.gov), Stryker’s discount rate can be increased over the next couple years. Firms like to estimate their future payments of pension and defined benefit plans conservatively over the inflation rate yet between the T-bill rate and the projected future returns on their investments. As the T- bill rate is considered the “risk-free” rate of return, it is reasonable to assume that the firm can make a return over that by investing in other securities. By taking a look at the 5-year return on the S&P 500, which is 11.622% (standardandpoors.com), it can be concluded that making enough from investments in the market to cover the discount rate for the pension plans would be fairly easy. Stryker conservatively states that they plan on a return in the 6.3% range, according to their 10-K. This seems relatively low. We can safely assume that Stryker is conservatively overstating their liabilities.

Conclusion

According to the information regarding the Key Accounting Principles and the ways in which they have been evaluated above, we can reasonably conclude that Stryker is making little to no bias in their accounting methods and disclosure principles. Their full and untainted disclosure of their research and development expenses is logical compared to the rest of the industry, especially when taking their market position into consideration. Stryker’s use of operating leases and lack of long-term debt or capital leases is a clear representation of their financial stability and efficiency. And the

planned out amounts of pension plan benefits and returns shows that they are utilizing a fair method of projecting future liabilities.

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Accounting Flexibility

One of the most important pieces of information used to evaluate a company is the accounting procedures used to develop the income statement, balance sheet and statement of cash flows. The flexibility of accounting refers to how companies can alter information to reflect either an increase or decrease in the actual standing of the

company. Certain policies are closely watched by the Federal Accounting Standards Board (FASB), such as research and development expenses, but other areas are left more to accountants to determine. This is where accounting numbers can be

misconstrued and stretched to appease shareholders and executives. The intentions behind the accounting flexibility section are used to determine how accurate Stryker and the industry are at representing different aspects of the financial statements.

Flexibility of Research and Development

The area of research and development is closely watched by the FASB and the SEC which leads to little flexibility among different firms. All research and development costs are required by GAAP to be expensed, which can dramatically mislead financial statements. In most technology driven industries, large amounts of research and development are necessary in order to thrive over their competition and maintain market share. The medical instruments and devices industry is in accordance with this philosophy, which is unfortunate to the financial statements. The following chart explains what happens when research and development is expensed as opposed to capitalized.

ASSETS = LIABILITIES + EQUITY REVENUES -- EXPENSES = NET INCOME U O U N O U

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With research and development being directly related to revenue, these expenses should be capitalized as an asset and amortized. Yet, with no accounting flexibility in this area, these costs have to be expensed making technologically dependent companies look undervalued.

Flexibility of Capital and Operating Leases

In the area of capital and operating leases, there is a much greater flexibility option for the accountants to decide upon. Companies can decide between two different types of leases that have different components and can alter the financial statements dramatically. Capital leases allow the company to take direct ownership of the firm and its equipment or buildings with leasing liabilities. Operating leases allow the leased asset to be leased to the firm for a number of years and then returned back at the end of the leasing period. The difference between these two types of leases effect the amount of liabilities and assets indicated on the balance sheet and the amount of leases actually possessed by the firm.

ASSETS = LIABILITIES + EQUITY REVENUES -- EXPENSES = NET INCOME U U N N N N

The medical instruments and devices industry can utilize both capital and

operating leases. Most companies in this industry try to minimize the amount of leases because factories and production facilities are owned and presented as an asset on the balance sheet. The only areas of Stryker that are leased are the various manufacturing and office facilities and equipment that are categorized as operating leases. Stryker expects their leases to lower year after year until there is not any long-term debt left on the books.

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Pension Plans

Pension (defined benefit) plans are for employees’ retirement needs. The amount the company spends each year concerning their employees’ retirement funds are determined by the number of employees, average age of retirement for employees, the number of employees reaching the retirement age, and a discount rate configured by accountants. This amount of money spent on pension plans can significantly affect the balance sheet of the firm by increasing or decreasing liabilities. The total liabilities on the balance sheet can be identified as an aggressive or conservative approach to stating the pension plans of the employees. If firms choose to understate pension plans on the liabilities section of the balance sheet, then the firm can appear more profitable than they actually are. In accordance with GAAP, companies are supposed to make their accounting numbers as conservative as they can, but pension plans is an example where this rule can be violated. With the pension discount rate and the total liabilities being inversely related, firms can easily misconstrue the amount of money allocated to liabilities on the balance sheet by simply increasing or decreasing one of these items.

ASSETS = LIABILITIES + EQUITY REVENUES -- EXPENSES = NET INCOME N U O N U O

Above, the over-under analysis displays the relationship between each section of the balance sheet and income statement and how an increase in pension plan funding can affect every aspect of the financial statements.

Each firm has the ability to increase or decrease the value of pension plans due to the flexibility GAAP has allowed with little or no consequence. This flexibility does allow companies to better describe their economic standing in the industry as well as diversify themselves among the competition, but needs to be closely monitored in that the firm has more opportunity to distort their financial position.

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Evaluate Accounting Strategy

There is a great importance in evaluating the accounting strategy that each firm chooses to use. Management has a large financial investment in the company whether that is through being a shareholder or an interest in job security. With this interest in the firm, managers have incentives to distort the financial situation of the firm, which creates a larger appeal. Management can accomplish this by distorting revenues and expenses to their benefit. Accounting areas that are prevalent to the medical

instruments and supplies are research and development, capital and operating leases, and defined pension plans. These areas can be misconstrued to overvalue the firm and make it look more profitable to invest in. A key indicator of how accurate a firm is being in their financial statements is to consider the transparency and conservatism the firm uses. The more information a firm provides to the public, allows investors to decide how true their finances are.

Research and Development

The medical instruments and supplies industry focuses on research and development as an accounting policy that is not flexible to GAAP standards. With Stryker being an innovatively thriving market, their financial statements are not reflected as such. Stryker spends six percent of all revenue on research and

development and is not able to capitalize any of this money due to accounting policies. Therefore one of their largest assets, research and development, has to be expensed lowering the assets of the firm.

In innovation driven industries, research and development is forced to be expensed, which can cause management to alter financial statements to alleviate the large amount of expenses. With research and development not being recognized as an asset, expenses are overstated and net income is understated because these two financial items are inversely related. With net income being understated, that can dramatically affect the view of the company to investors. Stryker and its competitors all

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spend millions of dollars on research and development annually. With GAAP’s restriction on expensing R&D, management lacks flexibility that makes firms overcompensate for expenses and assets in some other way. This causes a huge misrepresentation on the financial statements and misleads investors.

Capital and Operating Leases

A company chooses to classify leases as capital or operating leases. Liabilities and expenses can be affected if these leases are not recorded correctly. Stryker and its competitors record their leases as operating leases most of the time because it keeps the lease off the balance sheet minimizing liabilities and expenses. Companies in the medical instruments and supplies industry experience such a large amount of expenses just because of research and development that they need to minimize other expenses as much as possible which is a direct result of the use of operating leases.

If management manipulates the financial statements to reflect a more positive quarter for the company, they can do this by recording leases as expenses and not as a liability. This will reduce the amount of liabilities on the balance sheet and increase expenses on the income statement. Many companies do this to represent the company more highly, but it is against GAAP and they can be held liable for these accounting adjustments. Stryker and its competitors have in the past and continue to represent their operating leases as liabilities on the balance sheet to accurately value their company.

Pension Plans

Companies with many employees incur a great amount of expenses every year in the form of pension plans. Each employee seeks benefits for health care and

retirement that are expensed to the company. Pension plans, as explained above, are decided by many factors including the number of employees, discount and growth rates, number of employees reaching the age of retirement and the average age an employee retires with the firm. The estimates management makes to decide how much to spend on pension plans are just that, estimates. An increase or decrease in the

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discount rate per employee can drastically alter the amount of money expensed on the balance sheet.

Pension plans are great for employees of the company, but are costly to firms and investors. Investors look into the discount rate and how it compares with

competitors. Stryker has a discount rate lower than its competitors, Smith and Nephew and Biomet, which increases liabilities and expenses making Stryker look like the more conservative company. Stryker’s competitors may have a higher discount rate in order to compensate for some other liability or expense for the year.

Management is able to manipulate pension plan expenses especially due to more flexibility with accounting principles. Managers are influenced by shareholders and therefore are willing to increase or decrease the amount of expenses and liabilities concerning pension plans.

Conclusion

The accounting strategies used by the firms are a great way to interpret the daily activity for investors and management to overview. But the downside is that managers can manipulate areas of the financial statements to make a firm appear more profitable. With increased pressure from shareholders and top level executives, managers feel the need to adjust finances in order to have job security and a protected retirement fund. Research and development, capital and operating leases, and pension plans are

common ways for managers in the medical instruments and supplies industry to

manipulate finances. These activities devalue a firm and make them appear financially unstable.

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Quality of Disclosure

Qualitative Disclosure is described as how useful the information firms provide in their financial statements is to business analysts and potential investors. Managers of companies have some flexibility in this area and can make financial statements more or less easy to understand depending on how they choose to disclose information. The better the qualitative disclosure the more confidence investors have in their analysis which makes their conclusions more reliable. On the other side, some companies try to hide flaws in the company by providing inadequate disclosure. Although accounting rules require a certain amount of minimum disclosure some companies refrain from full disclosure to keep from giving away their strengths or to hide their weaknesses. Other firms disclose large amounts of useless information in an attempt to cover up problems they may be having. Therefore, disclosure is a very important part of accounting quality.

Qualitative Analysis

Stryker Corporation does an adequate job disclosing information about all aspects of the company. Their financial reports are very transparent and provide a good understanding of the firm’s recent performance and financial position.

Management clearly describes what is going on within the industry, their competitive position, and plans for the future. In their annual report or 10K, Stryker gives a detailed explanation of how each segment of the company is doing and how much of each product they sale. They breakdown their company by each type of product such as orthopedic products or hip and knee replacements, and then disclose what is going on with each one. A large portion of Stryker’s sales are done internationally so they are very careful to account for fluctuations in currency rates in figuring net income. They cautiously explain that financial results can be greatly affected by changes in currency rates or weak economic conditions in foreign markets. In the “Other Matters” section of the 10K, Stryker informs investors that they have entered into foreign currency

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nonperformance by other parties. Stryker also does a good job of using footnotes to